Log inMarket Update 18th April 2024 – Which will be the first domino to fall? – from Jilly Mann
Asked at his news conference of April 7, 1954, to comment on the strategic importance of Indochina to the free world. President Dwight D. Eisenhower responded as follows:
“You have broader considerations that might follow what you would call the ‘falling domino’ principle. You have a row of dominoes set up, you knock over the first one, and what will happen to the last one is the certainty that it will go over very quickly.”
The falling domino principle feels decidedly apt in the current context of global interest rates, equity valuations and international relations. In this update, we will consider these three key areas and try to establish what the first domino may be in each scenario.
- ECB – the first to blink
- UK interest rates and inflation explained
- Jerome Powell’s perfect landing
- Equity valuations – broader than you may think
- Deteriorating international relations
- 2024 – Year of the election
- In Summary
ECB – the first to blink
The last 18 months have seen Central Banks across the US, UK and Europe diverge in terms of decision making. They all hiked rates concurrently, then paused concurrently, but what we don’t yet know for sure is who will cut first, or if indeed they will all cut concurrently.
I don’t expect interest rate cuts to be timed uniformly across the US, UK and Europe. As things stand, I expect Europe to cut interest rates first. Christine Lagarde, President of the European Central Bank (ECB), has announced that she intends to cut interest rates in Europe in June 2024. She hasn’t confirmed by how much she will cut rates, but she sent out a very clear message that she views the disinflationary economic conditions in Europe as being such that she intends to take action, even if the US and others are intent on delaying their decisions about cutting rates. It would take a significantly unexpected rise in Eurozone inflation numbers, for the ECB to not carry through with these cuts in June.
UK interest rates and inflation explained
In our view, the UK should have led the charge on cutting interest rates before now, but Andrew Bailey, Governor of the Bank of England, has flip flopped with his messaging about when he will likely cut UK interest rates. Markets had been expecting to see cuts in May this year, but despite previous supportive messaging, he is now mooting delaying UK interest rate cuts in an attempt to see inflation in the UK fall even closer to the historic 2% target.
This week has seen the Office of National Statistics (ONS) release their latest UK jobs data report, covering the period December 2023 to February 2024. The results show that UK unemployment has risen to 4.2%, ahead of the expected rate of 4%. This rise suggests that the UK’s resilience to withstand interest rates at elevated levels is perhaps dwindling.
The Consumer Price Index (CPI) in the UK fell to 3.2% in March 2024, from 3.4% in the previous month. CPI tracks the prices of 700 products and services that make up the national shopping basket.
CPI is often the rate by which state benefits, final salary pensions or even domestic bills rise annually. However, to complicate matters, inflation in the UK is also reported using other measures than just CPI. For example, core inflation, which strips out some of the more volatile sectors such as energy, food, alcohol, and tobacco dropped from 4.5% in February to 4.2% in March. The theory behind the core inflation measure being that people still need to buy food and energy regardless of the price and so after excluding those essentials we can see a clearer measure of the rest.
Services inflation is another key measure and is one that the Bank of England often place more value upon. Services inflation looks at sectors such as education, hospitality and culture; essentially anything that is service-related. Given that the UK is in the main a service-led economy, rather than a production economy, services inflation is considered to be a relatively reliable measure of the UK labour market and unemployment. Services inflation fell to 6% in March, from 6.1% in February. Whilst this was a drop, it wasn’t as big a fall as economists had anticipated. Wage growth in March remained high, but was also falling from previous levels.
The graph above shows CPI in the navy dotted line, core inflation in green and services in black over the last 10 years. The trend for all is clearly downwards, but still some way above the historic target of 2%, which was trended around until mid 2021.
If we compare the March inflation figures across the UK, US and Europe, the UK is at 3.2%, the US has risen slightly to 3.5% and the Eurozone is estimated to come in at 2.4%.
This all seems quite supportive of a UK interest rate cut being imminent, but Andrew Bailey’s latest rhetoric is more about how much data of this ilk does he need to see, before he can be confident that the inflation genie is back in the bottle. One potential fly in the ointment for the UK’s April figures, could be the rise in the National Living Wage which came into effect at the start of the new tax year in April, but this is unlikely to have the same impact on the overall inflation numbers as the Russia/Ukraine war for example.
Whilst economists believe a May rate cut should be viable based on data, the widespread belief is that Andrew Bailey will wait for at least the June meeting before announcing a rate cut. Even then, he may delay until August or even a worst case scenario of November if he wishes to err further on the side of caution and simply track the US market. In our view, the UK should follow the ECB’s lead and take action sooner rather than later to minimise the impact of higher for longer rates and provide some relief to the UK market and consumers. Sadly, we don’t have much confidence in Andrew Bailey to do what the UK needs him to do.
Jerome Powell’s perfect landing
The US has been the hardest market to predict accurately in terms of Federal Reserve rate cuts. Inflation has remained higher in the US than in the UK and the stock market has continued to be led higher by a handful of technology names. As it stands today, Jerome Powell, Chair of the US Federal Reserve, may cut in either June or July this year. June will provide him with the next quarterly inflation figures and this may sway how he proceeds with interest rate cuts.
At the start of 2024, forecasters were predicting that the US would cut by 2.25% over a 2 year period, today the expectation is closer to 1.7% over a 2 year period. For comparison, the same forecasts show an expected 1.7% cut by the ECB and a 1.6% cut by the Bank of England over the next 2 years.
These predictions are based on a perfect outcome for markets; a soft landing, growth continuing to hold up and disinflation at the required rate. In this scenario, the US bond market would effectively factor in a 0.25% cut every quarter. The theory being then that both bonds and equities do well in that environment.
The difficulty is that the labour market in the US doesn’t seem to be strong enough to support this perfect soft landing scenario. If the labour market weakens further and faster than predicted, Jerome Powell will act quicker and will cut interest rates by larger amounts. The bond market in this instance will also accelerate. By that I mean that returns from bonds will turn higher more quickly, whilst equities will likely suffer due to concerns over continued growth expectations. The chart below is generated by the Federal Housing Administration in the US and shows the number of new mortgage delinquencies (arrears) caused by unemployment dating back to the start of 2008.
As can be seen, the number has started to spike upwards through 2023 to a level which outstrips the Global Financial Crisis of 2008.
US jobs data can be deceiving at face value as it reports the number of jobs per se. However, what is actually happening is that the number of people employed in full time jobs is falling, whilst the number of people in part time jobs is rising. This suggests that people are having to take on more jobs to achieve the same level of income required to pay their bills, as companies reduce their full time, higher paid, workforces. In addition, if one person has 2 or 3 part-time jobs, these are all reported as jobs, thereby distorting the true picture.
The race for the White House in the US is a distraction for markets and the Federal Reserve. It is impossible to ignore the ill-feeling towards Jerome Powell from Donald Trump and a strong economy with the commencement of a rate cutting cycle would be good news for Joe Biden’s campaign. The problem that Jerome Powell has is similar to the UK. He is looking at a specific sub-set of US inflationary data and so whilst the overall picture is rosy and the stock market continues to track higher, until he sees enough wobbles in the jobs data, he seems ready to sit tight on rate cuts.
Whilst sentiment is pushing towards this perfect landing, there are some discriminatory signs within the bond market that perhaps aren’t grabbing the headlines. Over 45% of the calendar year new bond issuance in the US had already happened by the end of the first quarter. That is a high proportion in what are uncertain times. Default rates in some higher yielding, lower quality, bonds are rising, but most of the stressed debt is emanating from issuers who are known to be in trouble. Fund managers such as the Janus Henderson fixed income team earn their corn by identifying those problem areas and avoiding them. A fixed income index fund which is buying positions in thousands of underlying bond holdings cannot differentiate between those assets which are strong and those which are stressed and so it is important to be invested in the right areas, reinforcing the importance of experienced active management in this area.
We are on the cusp of interest rate cuts and our portfolios are heavily biased towards UK and European fixed income assets, which will benefit most from the ECB cutting rates, potentially ahead of the US and UK. A 1% cut in interest rates could potentially lead to a 12% rise in bond returns. We have already seen this optimism play out in late 2023 when Central Banks stopped raising rates and we would expect the increased certainty around interest rate cuts to accelerate these returns so that they come through ahead of the actual rate cut announcements.
Equity valuations – broader than you may think
Turning to equities, 2024 has delivered some strong returns, not just from the Magnificent 7 US technology names.
Ahead of the UK Budget in March, we added the JO Hambro UK Equity Income fund to our portfolios in the belief that the Chancellor may offer some incentives to UK companies. He did announce a UK ISA, but this doesn’t come into effect until April 2025 and some of the incentives for UK pension funds to back UK stocks, were also on a staggered basis. These are unnecessary delays to our mind, but nonetheless, we have seen a bounce in the fund and it is just one example of us being able to generate returns in portfolios despite our defensive stance overall. The graph below shows the performance of the JO Hambro UK Equity Income fund in blue (6.35%, alongside the JPM Natural Resources fund in red (12.08%) since the 15th March 2024, when we bought the JO Hambro fund.
JPM Natural Resources is a fund that we have held in our portfolios for a while, more as a defensive underpin to global events. 2024 has seen a rally in gold and copper prices, whilst oil has remained relatively stable. This fund will fluctuate more than others simply due to the different factors which impact the price of commodities, but at times like this, we see the benefits of maintaining a position here.
The US is the headline equity market and we don’t hide the fact that we aren’t trying to chase the US market. We have very limited exposure to the big technology names through the Titan Global Equity fund, but interestingly, through 2024, our exposure to the Schroder US Mid Cap and the Premier Miton US Opportunities funds has performed equally well.
The Schroder and Premier Miton funds don’t hunt in the technology market, they are small to mid-cap biased and are often in industrial, material type names. We remain concerned about equity valuations, especially in the US. We consistently say that we don’t expect a huge bubble bursting as happened in the Technology Bubble at the turn of the century, but we do expect stock underperformance and some potentially hefty falls in a number of names. The fact that earnings reporting season causes quite so much speculation amongst analysts as it does at this moment highlights how on edge the market is. It won’t take much in the way of companies missing their targets and reporting weakness for the market to move sharply downwards, thus setting off the domino principle I opened with. Such movements may not be justified, but the levels at which they are currently trading mean that justified or otherwise, they will be punished and will in turn drag the broader market down.
We continue to be in a stock pickers market. With all that said, we are seeing opportunities in European equities to buy back in, there are opportunities to increase our UK allocation and to look at Emerging Markets, where equity valuations remain more attractively priced for the next phase of what should be a rate cutting cycle.
Deteriorating international relations
The Cold War, which lasted through the 1950s to the late 1980s, has been referenced in previous market updates and developments of late have done little to diminish my view that history may look back on this period as a time of the Cold War Mk 2. Thus far, the conflict in Gaza has largely left the markets unmoved and the war in Ukraine has sadly become a status quo with little impact beyond the states immediately involved. The latest threat to world peace between Israel and Iran could prove far more challenging for markets if matters escalate from here.
At face value, global leaders are urging restraint in Israel’s response to the Iranian attack of last weekend. China, Russia and the Western leaders are all reported to be urging a calm response, albeit probably for different reasons. If Israel do follow through on their warnings of an impactful reaction to Iran, then we may well all end up with a far bigger issue than simply what is happening in markets. I won’t go into the ramifications of who supplies what weapons to whom and for what purpose, but the world could do without the threat of nuclear (or other) attacks in the Middle East, that may then in turn spread beyond the region and cause a domino principle.
The hope at the moment is that calm will be restored and that no action will be taken on either side to stoke the flames. In that scenario, markets will move past the Israel/Iran tensions quickly. An indicator that markets are expecting this outcome can be seen in the movement of the oil price the last week.
There have been no great moves either upwards or downwards in oil price (green line), even on Tuesday when broader equity markets were slumbering over delayed interest rate cuts. The gold price (red line), which has been soaring lately, has continued to move upwards, but this has continued a longer term trend in recent weeks.
Should Israel decide to follow a different path in response, then we would expect to see a sharp uptick in both the oil price and the gold price. Defence stocks such as BAE Systems would bounce higher, whilst the majority of the stock market would likely fall back. We would also see a flight to quality in the form of buying Government Bonds (Gilts) and US Treasuries.
An escalation in Middle East tensions is not our default case and so we hope that the domino principle is avoided in the region, but should it happen, we are already well positioned given our defensive portfolio positioning.
International relations in the 2020s seem to be as poor as they have been for generations. I can’t see a scenario where that is going to improve in the near term. There needs to be a change in leadership and policy in too many regions for that to happen. Containment rather than appeasement or indeed pacts appear to be the only option at present and perhaps we become so focused on our Home Policy (i.e. UK taxation, inflation, impact on our day to day lives) that we underestimate the domestic and global diplomacy efforts which are ongoing behind the scenes to maintain as much peace as we presently have, but which is still not enough.
We are typically taking a more domestic view with regard to portfolio allocation at the moment. This feels sensible given what is happening globally and should provide some protection as we live through this unsettled phase.
2024 – Year of the election
Whilst we focus naturally on conflict, let us not forget that 2024 is also the year of the election. The US remains as confounding as ever, with seemingly around 342 million people living in the US, the leadership boils down to a contest between Joe Biden, an increasingly unsteady 81 year old and Donald Trump, an increasingly embattled 78 year old (as he would be at the time of inauguration). It defies belief that from such a sizeable population, there are not at least credible and known successors in place for either of these two candidates as and when the time comes. I have summarised the election timescale below, as it rumbles on quite a while in the US.
- Republican candidate to be confirmed in July 2024
- Democratic candidate to be confirmed in August 2024
- Presidential debates – September to October 2024
- 5th November 2024 – election day
- 17th December 2024 – Official electoral college votes
- 20th January 2025 – Inauguration Day
The Indian General Election is also taking place between April and June 2024, not a swift process given the scale of the country and the logistics of gathering as many votes as possible from remote regions. India is one of the largest democratic countries in the world and so whilst we may not feel that either a reinstatement for Narendra Modi or the appointment of a rival has much impact on us day to day, a growing, sustainable and prosperous India which remains democratic and open to business from overseas is crucial for long-term growth everywhere and so we will be watching the result with interest.
In Summary
To sum up, 2024 has thus far delivered little in the way of substance beyond speculation and headlines. The longer that interest rates are held, the more the urge to chase returns and believe in a perfect soft landing can grow stronger. As ever, we must be led by our beliefs and the data which we are reading. This may be frustrating for readers who, like us, want to see and had hoped to see by now, interest rate cuts, bond outperformance and a stabilisation in global affairs.
Now is not the time to change course, we believe that the dominos are about to fall, set off by the ECB. If anything, worsening global relations support our defensive positioning, irrespective of interest rate cuts. Central Banks announcing their readiness to cut, means that 2024 could be a year of opportunity for us. We are well positioned to avoid any fallout in equity markets, benefit from the rise in bond markets and buy into unloved equity markets that are poised to outperform.